––– a weblog focusing on fixed income financial markets, and disconnects within them

Tuesday, February 3, 2015

S&P Settles: Now How About that US Bond Rating?

In its settlement with the Department of Justice, S&P has backed off its assertion that the federal lawsuit was filed in retaliation for its 2011 downgrade of US Treasury debt. But the downgrade subjected S&P to a barrage of criticism both at the time and ever since, raising the question of whether the decision was appropriate. My view is that the downgrade was the correct credit decision in 2011, but that it is now time for S&P to restore the US to AAA status.

Since rating agencies earn minimal revenue from sovereign ratings, the downgrade was clearly not in the firm’s short term commercial interest. This speaks well for the sovereign group and senior management at the time: the analysts looked the numbers, decided that the US was no longer a triple-A credit and were allowed to implement and publicize their decision. While we often hear negative generalizations about rating agencies, it is worth noting that these firms are heavily siloed; the behavior of the structured finance group does not necessarily reflect on the work of the sovereign team.

Not only was the downgrade principled, but it was also justified. In 2011, the US debt-to-GDP ratio was skyrocketing, the country had an unsustainable fiscal outlook and it lacked the political will to deal with the imbalance between future revenues and swelling entitlements arising from baby boomer retirements. While the British and Italian governments were able to address population aging by raising taxes and delaying eligibility for social insurance programs, divided government in the US prevented a grand bargain from occurring here.

Further evidence that the US did not merit a top credit rating emerged in October 2013 when both parties engaged in brinkmanship over raising the debt ceiling. Had the debt ceiling not been raised, the Treasury would been forced to prioritize payments. While I believe that the Treasury would have prioritized debt service over other obligations, my confidence in this belief does not approach the 99.9%+ level normally associated with AAA ratings.

So what has changed and why am I suggesting an upgrade? First, after taking widespread blame for the debt ceiling debacle, Republicans have changed tactics. It is now extremely unlikely that they will trigger a similar confrontation when the debt ceiling has to be raised again. Since failure to raise the debt ceiling and failure to prioritize debt service are both low probability events, the chances of both occurring seem to be within the AAA risk band.

More relevant to S&P’s original downgrade decision, the nation’s fiscal long term outlook has changed since 2011. When I say this, I am not referring to the marked decline in headline deficit numbers. The fact that the annual deficit declined from $1.3 trillion in fiscal 2011 to a projected $468 billion in fiscal 2015 is not a surprise. Looking back at CBO’s ten year projection from 2011, the agency estimated a $551 billion deficit for the current fiscal year – pretty close to what we are actually seeing. While politicians from both parties may be congratulating themselves for this improvement, the downward deficit trend is exactly what one would expect from an improving economy. Rising tax revenues and lower unemployment insurance costs – not any major reform – are reducing the deficit. There was no grand bargain, nor is there likely to be one anytime soon.

But two developments since 2011 have greatly altered the country’s longer term outlook: reduced healthcare cost inflation and persistently lower interest rates. Between 2000 and 2007, annual healthcare expenditure growth averaged 8.5%. Since 2009, the rate of growth has averaged only 3.9% and health expenditures have stopped rising as a percentage of GDP. Back in 2011, the decline in health cost inflation could be dismissed as a temporary effect of the Great Recession – but now that it has persisted into the recovery, we apparently have a lower baseline rate. Since healthcare costs are such a large component of future federal spending, less cost escalation in this sector is a very important factor in the long term fiscal outlook.

Last year CBO projected that in 2039 the US debt/GDP ratio would reach 106% under current law and 183% under a likely set of alternative policies. As healthcare disinflation persists these forecast levels are likely to fall.

Lower interest rates should also slow the accumulation of debt. After years of recovery and many months after the end of quantitative easing, Treasury rates remain near record lows. Rather than assume that rates will return to pre-recession levels, it now seems more reasonable to assume that we have entered a new normal of ultra-low rates just as Japan did after 1990.

While discussion around government solvency often revolves around a nation’s debt-to-GDP ratio, a better measure is the ratio of interest expense to revenue – because it focuses on the government’s ability to maintain debt service. Just after World War II, Britain reached a debt-to-GDP ratio of 250% but did not default because it faced very low interest rates. If interest rates remain low in the US, the federal government can comfortably service the 183% debt load envisaged by CBO’s most pessimistic scenario.

In 1991, the nation’s interest/revenue ratio peaked at 18% - but there was no discussion of a default. Currently, the ratio is below 8%. My study of fiscal history suggests that a Western style government becomes vulnerable to default once this ratio reaches 30%. While the US can always avoid a default by printing money, it is possible that an independent Fed Chair would refuse to do so, out of fear that the resulting price inflation would have worse consequences than a Treasury default.

Under the CBO’s most pessimistic scenario, the interest/revenue ratio reaches 46% in 2039, well into the danger zone. But this outcome assumes an average interest rate on federal debt of 4.85%. Right now this average is below 2% and falling as higher coupon bonds mature and are replaced by new low-rate issues. Even if the government’s average financing rate drifts up to 3%, its interest/revenue ratio will remain below the critical threshold.

S&P had good reason to downgrade the US in 2011. If health cost inflation and interest rates had returned to pre-recession historical norms, the case for the lower rating would still be strong. But now that we have entered a new normal of quiescent healthcare cost escalation and low interest rates, it appears that the US is due for an upgrade.